C.D. Howe Institute
Backgrounder
www.cdhowe.org
No. 68, January 2003
How Canada’s Tax
System Discourages
Investment
Duanjie Chen and
Jack M. Mintz
The Backgrounder in Brief
Canadians cannot sit back and believe that they have
achieved their best in cutting taxes on business and
entrepreneurial investments in the past few years.
Federal and provincial budgets should provide additional
personal and corporate tax cuts to improve Canada’s
productivity performance.
About the Authors
Duanjie Chen is a Research Associate, International Tax Program, Rotman School of Management,
University of Toronto.
Jack M. Mintz is President and CEO of the C.D. Howe Institute, and Professor of Taxation,
J.L. Rotman School of Management, University of Toronto.
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C.D. Howe Institute Backgrounder
A
Canada’s tax
treatment of
depreciation,
inventory costs
and the general
absence of capital
taxes in the United
States puts
Canadian
investment
projects at a
significant
disadvantage.
fter recent cuts to corporate- and capital-gains taxes, with more to come
from Ottawa and some provinces, Canadians may feel that their tax
system is now competitive for corporate and entrepreneurial
investments and that further actions to cut corporate and personal taxes
on investments are unwarranted. Not so. With the 2002 tax measures adopted in
the United States, Canada’s effective tax rate on capital is well above US rates.
Even though Canada’s statutory tax rate on corporate income is now below that of
the United States and will fall even lower by 2006, the tax treatment of
depreciation, inventory costs and the general absence of capital taxes in the United
States puts Canadian investment projects at a significant disadvantage. As well,
relatively high personal taxes on income derived from capital discourage
Canadian entrepreneurial capital investments, a disadvantage that will be made
greater if the Bush administration succeeds in getting congressional approval for
exempting dividends from taxation. The lack of investment resulting from high
business and entrepreneurial taxes will undermine attempts to improve
productivity and innovation in Canada. Federal and provincial budgets should
provide additional corporate and personal tax reductions to improve investment
and entrepreneurship.
Federal and provincial governments began cutting corporate and personal
taxes in 2000, creating a better business environment for investment in Canada.
Ottawa reduced the federal corporate income tax rate a further two points on
January 1, 2003, and it will fall another two points to 21 percent by 2004. After
delaying a reduction, Ontario is now planning to cut its corporate income-tax rate
further, from 11 to eight percent, and Alberta may further reduce its rate in the
future. Several other provinces, such as New Brunswick and Manitoba, have
planned further corporate tax rate cuts as well. Also, some provinces, particularly
British Columbia, Quebec and Alberta, are reducing or eliminating capital taxes.
Federal and provincial governments also reduced personal taxes on income
derived from investments (dividends, capital gains and interest) and other cuts are
planned.
These tax cuts are welcome because they encourage capital investment.1
Canada lags the United States in investment in such areas as manufacturing
(Bernstein, Harris and Sharpe 2002), compromising Canada’s ability to produce
and sell more products and services. Capital investment supports innovation and
productivity because investments in new equipment and structures are critical to
entrepreneurs looking to put their ideas in practice or to adopt new technologies.
With greater capital investment, workers benefit from higher incomes arising from
improved productivity.
Are these tax cuts sufficient, however, to make Canada more competitive for
business investment? In this Backgrounder, we provide estimates of effective tax
The authors wish to thank Finn Poschmann and Bill Robson for comments. They are especially
grateful to John Lester and other members of the Department of Finance for comments and
assistance with data. Any errors are our own.
1
Several studies have shown that capital investment is encouraged by reductions in taxes on
investment. See Mintz (1995) for a survey. See also Jorgensen and Yun (2001) for a recent analysis
of US tax reform that results in substantial economic gains by reducing levies on capital
investment.
1
2
C.D. Howe Institute Backgrounder
rates on capital for large corporate investments and entrepreneurial capital (the
latter applying to Canadians who carry out their activities through unincorporated
businesses and privately held corporations) and compare them to the United States
and selected countries. The overall conclusion is that Canada’s tax system remains
a barrier to capital investment in Canada, especially compared to the United States,
where recent measures have sharply reduced taxes on capital investments.
Substantial gains in productivity and income earned by Canadians could be
achieved if Canada pursues a path of further cutting taxes on investments in
upcoming federal and provincial budgets.
How Taxes Affect Capital Investment
A key criterion for
businesses
thinking about
capital
investments is that
the rate of return,
net of taxes, is
more than the rate
of return available
elsewhere.
A key criterion for businesses thinking about capital investments is that the rate of
return, net of taxes, is more than the rate of return available elsewhere. For
example, suppose a manufacturing business earns a risk- and inflation-adjusted
rate of return on an investment project of 15 percent, but is reduced by taxes by
one half to 7.5 percent. If 7.5 percent is as good as what an investor could get
elsewhere on an after-tax, risk-adjusted basis for an investment, then the investor
would be willing to provide funds to the business to undertake the project.
However, if 7.5 percent is below what an investor could earn elsewhere, such as
ten percent, the business will not be able to fund the investment. A business will
invest only in high-yielding capital projects, resulting in the pre-tax rate of return
to capital of 15 percent increasing by a sufficient amount — such as to 20 percent
— so that the business can offer an after-tax rate of return of, say, ten percent, that
can attract financing from owners.
Several taxes paid by businesses and people lower the rate of return that a
business can earn on investment. Business-level taxes include the corporate income
tax, asset-based taxes (including the capital tax in Canada and some similar taxes
in the United States) and sales or excise taxes on capital components.2 Canadian
personal taxes on investment income (dividends, capital gains and interest income)
also reduce the rate of return earned by Canadians who own stocks and bonds
issued by businesses.
However, depending on the nature of the business, Canadian taxes have quite
different effects on investment in Canada. Large multinational companies raise
capital from international markets to fund projects in Canada. Thus, Canadian
business taxes reduce the rate of return on capital offered by large corporations to
Canadian and non-resident owners who provide financing to Canadian businesses
through these capital markets. Such taxes will discourage investments made by
these large businesses. Canadian personal taxes on investment income are less
relevant to determining the international cost of funds for multinational
corporations because funds could be acquired from international markets if
personal income taxes discourage Canadian investors from saving and investing.
Such is not the case for Canadian-controlled entrepreneurial investments,
which depend on their Canadian owners to provide capital. Entrepreneurs provide
2
All three taxes are included in estimates provided later. Property taxes are excluded since no data
are collected in Canada to estimate property tax burdens by industry.
C.D. Howe Institute Backgrounder
over one-half of start-up business financing and about one-quarter of funding for
continuing operations of their privately held companies (Statistics Canada 2002).
Friends and relatives of entrepreneurs provide at least another ten percent of
funding. As well, in Canada some special corporate tax concessions are provided
to very small Canadian-controlled private corporations. For instance, small
business with taxable capital3 of less than $15 million can pay tax at a federal rate
as low as 13.12 percent (federal), as well as at lower rates in most provinces except
Quebec. The low rate of tax, which is about 15 points less than the rate applying to
larger companies, applies to the first $200,000 of active business income.
The Effective Tax Rate on Capital
Effective tax rates on capital are calculated by estimating taxes paid as a percentage
of the income earned by a project that has just enough revenue, after payment of
taxes, to attract funding from investors (the marginal project). Projects with high
(low) effective tax rates must earn higher (lower) pre-tax rates of return on capital
if they are to attract the interest of investors for a given after-tax required rate of
return on investments (see Chen 2000 for further discussion).
The effective tax rate on capital incorporates all the features of income, capital
and sales taxes that impinge on the use of capital in production.
For the corporate income tax, the effective rate depends not only on the
statutory corporate income tax rate but also on provisions for tax credits (research
and development and Atlantic investments) and the deduction of expenses related
to the economic costs incurred with holding capital. If the tax system provides cost
deductions and tax credits that have a tax value more than that if the economic
cost of holding the asset were to be deducted, the tax paid as a portion of profits is
less than the statutory tax rate (or vice versa). Further, debt financing reduces the
amount of corporate income tax paid on investments because interest expenses are
deductible from corporate income. On the other hand, capital taxes and sales taxes
on capital components increase the effective tax rate.
The effective tax rate as described above is a more complete measure of the
impact of taxes on investment than others more commonly known. People often
only compare the statutory income-tax rates to measure competitiveness, such as
the average federal-state corporate income tax rate of 39 percent in the United
States, 35 percent in Canada, or 28 percent in Sweden.4 While statutory tax-rate
differences matter for some economic decisions made by investors — for example,
3
The favourable small business rate is phased out when the Canadian-controlled private
corporation has more than $10 million in taxable capital (fully phased out when taxable capital
reaches $15 million). Taxable capital refers to the capital subject to tax under the large
corporations tax for companies. This tax applies effectively to gross assets of the corporation
(shareholders’ equity plus most forms of debt).
4
The Department of Finance uses for competitiveness comparisons corporate tax rates that are the
statutory income-tax rates, including capital taxes paid as a percentage of corporate taxable
income (see Federal Budget 2001, for example). This statistic is quite meaningless and confusing.
It provides no information about how investment might be affected because the statistic does not
adjust for other aspects of the tax system, such as depreciation and inventory-cost deductions or
sales taxes on capital inputs.
3
4
C.D. Howe Institute Backgrounder
businesses will shift interest income from
high- to low-statutory tax-rate jurisdictions
and interest expense from low- to highCanada
Canada
United States
statutory tax rate jurisdictions because the
2002
2006
2002
overall tax paid will be reduced by
(%)
deducting interest from income in the high
Forestry
31.9
29.2
15.7
statutory tax-rate jurisdiction and including
Manufacturing
18.8
18.2
16.8
interest in income in the low statutory taxConstruction
29.3
26.1
19.8
rate jurisdiction — capital investment
Transport
24.6
22.4
10.3
decisions will depend on all provisions
Communications
22.7
20.1
12.2
affecting marginal effective tax rates.
Electrical Power
29.5
18.4
13.8
It is, therefore, quite possible for a
Wholesale Trade
29.4
26.4
19.6
Retail Trade
29.4
26.8
17.1
country to have low statutory tax rates,
Other Services
30.6
27.4
19.2
which help counteract income-shifting and
Structures
22.1
19.7
17.8
protect the tax base in a country, but higher
Machinery
26.1
24.8
14.7
effective tax rates on capital investment if
Inventory
39.3
35.8
17.7
other provisions of the tax law erode
Land
22.1
19.5
17.7
competitiveness. This is important to keep in
Aggregate
24.3
22.2
16.8
mind because Canada’s federal-provincial
Source: International Tax Program, Institute of International Business,
average statutory corporate income tax rate
University of Toronto.
is about 35 percent in 2003 (possibly 31
percent by 2006), which will be less than the
average corporate income tax rate of 39 percent in the United States.
Table 1:
Effective Corporate Tax Rates on Capital
for Large Corporations: 2002 and 2006
Large Corporate Investments
Canadian companies investing in Canada and elsewhere face quite different tax
regimes across the world. Given the importance of the US market for investments
in Canada and the United States, we provide a sector-specific analysis of Canada’s
and the United States’ effective tax rates on capital in this section.5
Table 1 provides the effective corporate tax rates on capital by non-resource
sector in Canada and the United States. As discussed, Canadian personal taxes are
ignored because funds are raised from international capital markets. Two
calculations are provided; one for 2002 and a second for 2006, the latter assuming
that cuts in corporate income and capital tax rates at federal and provincial levels
have been fully phased in.
As is shown in the table, Canadian effective tax rates were well above US
effective tax rates by over seven percentage points in 2002 and will still be over five
percentage points higher in 2006. Thus, despite the reductions in statutory
corporate income-tax rates in Canada to levels below those in the United States,
5
Investments include structures, machinery, inventories and land. Research and development is
not included in these estimates as is done in Mintz (2001). The effect of the R and D tax-credit
regime is to lower the effective corporate tax rate by about a percentage point in Canada, in part
because R and D is a small portion of business investment. However, when research and
development grants are included, which is more common in the United States (see Mintz 2001),
differences between Canadian and US rates, aggregated for all industries, are virtually unaffected
by incorporating for R and D tax credits and grants.
C.D. Howe Institute Backgrounder
Table 2:
5
Decomposition of Canadian Effective Corporate Tax Rates
on Capital by Industry for 2006
Corporate Income
Tax Only
Corporate Income and
Sales Taxes on
Capital Inputs
15.5
22.8
29.2
Corporate Income, Sales
and Capital Taxes
(%)
Forestry
7.2
9.3
18.2
16.1
19.6
26.1
Transport
7.9
13.8
22.4
Communications
8.9
11.7
20.1
Electrical Power
9.4
10.5
18.4
Wholesale Trade
14.5
20.1
26.4
Retail Trade
12.3
20.0
26.8
Other Services
15.1
20.8
27.4
Structures
11.9
11.9
19.7
Machinery
7.5
22.7
24.8
Inventory
29.1
29.9
35.8
Land
13.7
13.7
19.5
Aggregate
12.0
16.8
22.2
Manufacturing
Construction
Source: International Tax Program, Institute for International Business, University of Toronto.
Canada’s business-tax system will remain uncompetitive even when the planned
cuts are fully phased in.
Despite the lower statutory tax rate in Canada, the higher level of taxation in
Canada arises for several reasons:
6
Federal and provincial governments levy capital taxes that are rare in the
United States.6
Canadian depreciation deductions are less generous than those provided in the
United States. With the adoption of accelerated depreciation in the United
States in 2002, US effective tax rates on capital have been reduced by over 1.7
percentage points averaged across all non-resource industries. This provision,
to be applied for the next three years, results in 30 percent of assets with lives
of less than 20 years being written off immediately, with the balance subject to
normal annual depreciation. Although the accelerated depreciation provision is
temporary, indications are that US policy makers in the next several years will
push for substantial corporate tax reform that might result in the provision
being made permanent or replaced by another provision that provides
substantial corporate tax relief in the United States.
Inventory cost deductions are less favourable in Canada than in the United
States. Canadian companies must write off, first, the cost of inventories
according to the oldest inventory in stock (First-in-First-out inventory costing),
For example, Massachusetts has a capital tax on tangible and net intangible assets applied at a
rate of 0.7 percent. However, most states do not impose such taxes at all. There is no US federal
capital tax. The Canadian large corporations tax is levied at 0.225 percent of assets, although the
amount is reduced by the corporate income surtax equal to 1.12 percent of profits. About 80
percent of Canadian companies pay some LCT.
6
Table 3:
C.D. Howe Institute Backgrounder
Effective Corporate Tax Rates on Capital for 2006
by Major Province
Alberta
British Columbia
(%)
28.1
Ontario
29.3
Quebec
Forestry
18.7
18.7
Manufacturing
12.5
15.3
17.8
16.2
Construction
19.8
24.6
25.2
22.1
Transport
12.6
19.7
22.5
16.5
while US companies can use the
cost of the latest inventory in
stock (Last-in-First-out). Even
with mild inflation, this provides
an important advantage to US
companies.
In Table 2, we provide a
breakdown of effective tax rates
Communications
13.6
17.2
19.4
17.1
in Canada for 2006 according to
Electrical Power
15.7
17.6
16.7
13.6
their components, including
Wholesale Trade
18.5
25.1
26.1
20.9
corporate income taxes, capital
Retail Trade
25.1
26.7
19.5
16.6
taxes and sales taxes on capital
Other Services
26.1
27.1
22.0
27.4
inputs. Corporate income taxes
Structures
16.1
17.2
18.5
18.9
alone result in an effective tax
Machinery
12.9
28.8
31.7
17.3
rate for non-resource industries
Inventory
35.5
34.3
35.0
33.6
Land
18.0
18.5
18.9
16.9
equal to 12 percent. Provincial
Aggregate
16.3
22.2
23.7
19.2
sales taxes on capital inputs raise
the effective tax rate to about 17
Source: International Tax Program, Institute for International Business, University of Toronto.
percent. Federal and provincial
capital taxes add a further five points to the effective tax rate, resulting in an
aggregate rate of 22 percent. Capital taxes raise the effective tax rate on structures
by more than 50 percent and increase substantially the effective tax rate on
inventories and land by almost six percentage points.
Effective rates also vary by province (Table 3). By 2006, Ontario’s effective tax
rate on capital will be 24 percent, British Columbia’s, 22 percent, Quebec’s, 19
percent and Alberta’s, 16 percent. These provinces account for almost 90 percent of
corporate profits in Canada. Compared to the United States, with an effective tax
rate of 17 percent, only Alberta will be competitive with respect to the taxation of
capital. Alberta’s advantage arises from having no provincial sales tax and capital
tax, with a relatively low corporate income-tax rate (taken to be 11 percent).
If Canadian effective tax rates on capital on large businesses were brought to
levels below or close to those of the US market, several policy actions could be
considered to eliminate disadvantages, beyond the planned cuts to corporate
income and capital taxes. For example, the full elimination of federal and
provincial capital taxes and the reform of provincial sales taxes to eliminate taxes
on capital components would reduce the effective tax rate on capital on average
from 22 percent to close to 12 percent by 2006, well below the US effective tax rate
on capital. If federal and provincial capital taxes were eliminated by 2006, the
effective tax rate in Canada would be just over 17 percent, close to that in the
United States.
Entrepreneurial Investments
Not only do business taxes reduce returns on investments for entrepreneurs, so too
do personal income taxes on dividends, capital gains and interest income. As
C.D. Howe Institute Backgrounder
discussed above, both
business and personal
taxes affect the
Corporate
Corporate
Personal
Personal
Personal
incentive to invest in
– Large
– Small
– Interest
– Dividends
– Capital Gains
entrepreneurial capital.
Canada
34.0–41.4
19.9
46.0
31.3
23.0
Canada is reducing
France
36.4
25.0
60.1
40.2
20.8
b
both
corporate income
Germany
n.a.
53.8
10.3
26.9
39.6
taxes and personal
Italy
40.3–44.5
n.a.
12.5–27.0
12.5
12.5
taxes as applied to
Japan
42.6
34.2
20.0
20.0
20.0
income derived from
U.K.
30.0
30.0
40.0
25.0
10.0
U.S.
39.5
20.9–39.7
43.7
43.7
23.6c
investments. Generally,
Ireland
10.0–20.0
12.5
24.0
20.0
20.0
federal and provincial
Sweden
28.0
n.a.
30.0
30.0
30.0
governments have
a
Personal tax rates are for the highest income investors.
lowered personal taxes
b
For participatory shares in a closely-held German business. Portfolio capital gains are exempt.
on income, the top rate
c
Includes state level personal taxes which are deductible from federal rates. Long-term (more than one year)
falling from over 51
gains are subject to a federal rate of 20.0 per cent and average state rate of 6.87 per cent in the US.
percent in 1999 to
about 46 percent in
2001. As well, since the
end of 2001, only one-half of capital gains are subject to tax, compared to threequarters in 2000. Dividend taxes paid by individuals are reduced by federal and
provincial dividend-tax credits to partly offset corporate income taxes payable
prior to the distribution of profits.
Countries exhibit considerable variation in their treatment of entrepreneurial
capital.7 At the corporate level, some countries, including, Germany, Italy and
Sweden, do not provide special tax concessions for small businesses. However,
Canada, France, Ireland (until 2004), the United Kingdom and the United States
have preferential regimes for small businesses. At the personal level, tax rates
depend on the progressivity of the marginal tax-rate schedule as well as reduced
levels of tax for dividends, capital gains and interest. The corporate and personal
income-tax rates by source of income are provided in Table 4.
Table 5 provides the 2001 estimates of effective tax rates on capital, combined
for both corporate and personal taxes. Two calculations are provided. The first is
for the medium-size case in which the small business provisions are not applicable.
The second is for the small-size case in which preferential treatment is provided for
entrepreneurs investing in companies of less than $10 million in asset size
(Canadian rules). Calculations are provided for manufacturing and service
companies.8 It is assumed that entrepreneurs finance investment by 60 percent
Table 4:
a
Corporate and Personal Statutory Tax Rates on
Investment Income for 2001
7
All these calculations are based on Chen, Lee and Mintz 2002. As personal tax data lagged one
year for cross-country comparisons, we could not provide 2002 calculations as in Table 1. Note
that there are some differences in assumed interest rates, inflation rates and other parameters for
2001 in comparison to 2002. See the above publication for further discussion of assumptions.
Personal taxes are calculated as a percentage of rates of return, adjusted for inflation. Capital
gains taxes take into account the deferral of tax arising from the holding of assets for ten years.
8
Note that there are some considerable differences in effective corporate tax estimates between
Table 1 and 5 for larger companies. This reflects differences in interest rates, inflation rates and the
net-of-tax rate of return on capital as well as lower corporate tax rates in 2002 compared to 2001.
7
8
C.D. Howe Institute Backgrounder
equity and 40 percent debt.9
Further, 40 percent of
shareholders’ income (equity) is
Large Firm
Large Firm
Small Firm
Small Firm
in the form of dividends, the
– Manufacturing – Services
– Manufacturing – Services
balance in capital gains.
(%)
For the large-company case,
Canada
corporate
27.7
28.1
12.0
9.5
the combined corporate and
personal
44.7
44.4
54.4
55.9
personal tax on entrepreneurial
combined
72.4
72.5
66.4
65.4
capital in Canada was 72 percent
France
corporate
13.6
15.2
13.7
19.5
in 2001. Although this is below
personal
78.5
77.0
78.4
76.7
effective rates in France and
combined
92.1
92.2
92.1
92.3
Germany, entrepreneurs in
Germany
corporate
28.4
19.5
28.4
19.5
Canada are more highly taxed
personal
52.8
59.4
52.8
59.4
than in Italy, 46 percent, Japan, 52
combined
81.3
78.9
81.3
78.9
percent, the United Kingdom, 63
Italy
corporate
22.0
29.0
19.4
26.4
percent, Ireland, 35 percent,
personal
23.9
21.7
24.7
22.5
Sweden, 53 percent and, to a
combined
45.9
50.7
44.1
48.9
lesser degree, the United States,
Japan
corporate
26.0
25.3
19.6
19.3
70 percent.10 The much lower
personal
25.6
25.9
24.7
28.0
effective tax rate in Sweden
combined
51.7
51.2
47.5
47.3
compared to Canada reflects the
U.K.
corporate
19.4
13.8
11.1
8.2
dual income-tax structure in
personal
43.3
46.3
47.8
49.3
Sweden where corporate income
combined
62.7
60.1
58.9
57.6
is subject to a tax rate of 28
U.S.
corporate
22.3
21.0
9.2
5.5
percent and dividends, capital
personal
47.4
48.2
55.4
57.7
gains and interest are subject to a
combined
69.7
69.2
64.6
63.5
tax rate of only 30 percent, well
Ireland
corporate
4.2
7.5
4.2
4.3
below personal taxes that apply to
personal
31.2
30.1
31.2
31.3
other sources of income.
combined
35.4
37.6
35.4
35.5
A case in point is Ireland,
Sweden
corporate
16.0
12.2
16.0
12.2
which has been the fastest
personal
37.2
38.8
37.2
38.8
growing industrialized economy
combined
53.2
51.0
53.2
51.0
of the past 20 years (Honohan and
Source: Chen, Lee and Mintz (2002)
Walsh 2002). Ireland’s relatively
low effective tax rate on
entrepreneurial capital is in part due to the low corporate income tax (10 percent in
manufacturing and 20 percent in services), as well as relatively low personal taxes
on income derived from investments.
The US rates would be even further below the Canadian rates if dividends are
exempted from taxation as recently proposed by President George W. Bush. The
Table 5:
Effective Corporate and Personal Taxes on
Entrepreneurial Capital For Selected Countries in 2001
9
An alternative set of calculations in which some of the entrepreneurial financing is in the form of
only equity is also provided by Chen, Lee and Mintz (2002), but the differences do not change the
relative comparisons in a material way. Investments that are more debt-financed have lower
effective tax rates at the corporate level but higher rates at the individual level since interest
income tends to be more highly taxed than dividends or capital gains for an investor.
10 With accelerated depreciation, the US effective tax rates as estimated for 2001 would be reduced
by a further 1.7 percentage points.
C.D. Howe Institute Backgrounder
impact would be to reduce the effective tax rate on entrepreneurial capital by about
ten percentage points.
For small firms, the effective tax rate on entrepreneurial capital in Canada
drops from 72 to 66 percent, reflecting the lower corporate income tax rate on small
Canadian-controlled private corporations.11 Even with the more generous
corporate treatment of small business in Canada, the effective tax rates in Canada
are well above those of other countries, excluding France and Germany.
Surprisingly, the overall tax imposed on entrepreneurial capital in 2001, taking
into account both corporate and personal taxes, is quite substantial in Canada. The
combined tax rate of 72 percent for large companies and 66 percent for small ones
is significant. It implies for each dollar of profit, adjusted for inflation and risk,
federal and provincial governments take at least two thirds of the return on
investments through corporate and personal taxes. Although the results do not
reflect some corporate tax cuts that were adopted in 2003 to be phased in by 2006,
the overall level of taxes on entrepreneurial income would remain well above 60
percent of inflation-adjusted income. Thus, despite the corporate and personal tax
cuts being considered, Canada’s tax system is onerous and uncompetitive with
respect to the taxation of entrepreneurial income.
Conclusions
The relatively high level of taxation imposed on business and entrepreneurial
capital in Canada should be of considerable concern to anyone hoping to see a
substantial improvement in productivity. Taxes impede capital investment by
reducing the return that investors can derive from capital projects in Canada. With
lower taxes, more investment projects could be brought on stream, improving
labour productivity and providing greater incomes for Canadian employees. The
improvement in productivity brought on by investment ultimately translates into a
higher standard of living.
From a taxation point of view, Canada looks less competitive than the United
States, despite the advantage of having a lower statutory corporate income-tax
rate. Even with the latest improvement in Canada’s growth, primarily due to more
robust employment and a recovery in resource prices, Canada’s productivity
remains below that of the United States (Bernstein, Harris and Sharpe 2002).
As an indicator for the future, the outlook for Canada in terms of attracting
investments in North America is not particularly bright when taking tax
considerations into account. Canada’s tax system creates a barrier to investments,
eroding our ability to improve labour productivity and adopt new technologies.
With our smaller market and less depth in capital markets, Canada’s natural
disadvantages are made worse by its tax system. Rather than adopting policies that
create a competitive advantage, most Canadian political leaders are pursuing tax
policies that create a disincentive for investment. It is true that taxes help pay for
some important public services, but as documented in Mintz (2001), the subsidies
providing advantages to businesses through our public programs are substantially
11 If small companies are all equity-financed by the entrepreneur, the effective tax rate drops from 73
percent (large-company case) to 63 percent (small-company case) for 2001.
9
10
C.D. Howe Institute Backgrounder
less than the disadvantages created by our tax policies. This should not be
surprising since a substantial portion of tax revenue is used to cover public debt
charges that provide no program benefits to Canadians.
Canadians cannot sit back and believe that they have achieved their best in
cutting taxes on business and entrepreneurial investments in the past few years.
Our standard of living will be significantly compromised in this decade if we
believe that we can veer from a course of tax reductions in the near future. Instead,
further cuts to corporate and personal taxes in upcoming federal and provincial
budgets would improve our productivity and incomes measurably. The lesson for
finance ministers and their leaders: Carpe diem.
References
Bernstein, Jeffrey I, Richard G. Harris and Andrew Sharpe. 2002. “The Widening Canada-US
Manufacturing Productivity Gap.” International Productivity Monitor, Centre for the Study of Living
Standards, Number 5.
Chen, Duanjie. 2000. “The Marginal Effective Tax Rate: The Only Tax Rate that Matters in Capital
Allocation.” C.D. Howe Institute Backgrounder. Toronto: C.D. Howe Institute.
———, Frank C. Lee and Jack Mintz. “Taxation, SMEs and Entrepreneurship.” STI Working Papers
2002/9. Organisation for Economic Co-operation and Development, Paris: OECD.
Honohan, Patrick and Brendan Walsh. 2002. “Catching Up with the Leaders: The Irish Hare.”
Brookings Papers on Economic Activity 1: 1–77.
Jorgensen, Dale W. and Kun-YoungYun. 2001. Lifting the Burden: Tax Reform, the Cost of Capital and US
Economic Growth. Cambridge, Mass.: MIT Press.
Mintz, Jack. 1995. “The Corporation Tax: A Survey.” Fiscal Studies 16(4): 23–68.
———. 2001. Most Favored Nation: A Framework for Smart Economic Policy. C.D. Howe Institute Policy
Study 36. Toronto: C.D. Howe Institute.
Statistics Canada. 2002. “Financing of Small- and Medium-sized Enterprises.” The Daily,
www.statcan.ca. Accessed: October 1, 2002.
C.D. Howe Institute Backgrounder
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